Doctor Copper

The Dow Jones Industrial Average and the S&P 500 Index established new all-time highs in September as the Dow produced a price gain (dividend reinvestment not included) of 9% for the quarter. The broader New York Stock Exchange Composite Index, however, remains well below its all-time high established in January – one of numerous divergences.

To a large degree the overall market has a case of halitosis – “bad breadth” – as fewer and fewer individual stocks are making new highs. In fact, only two stocks – Apple and Amazon – have accounted for almost 30% of the S&P 500’s entire gain for the year. Both Apple and Amazon reached record milestones of $1 trillion in market value during the period, leading one wag to suggest that Apple could now afford to buy a “whole apple.” Is it just us or is the air getting a tad thin?

The relative strength of the financial stocks, moreover, has been declining for more than six months. The financials have a history of being a leading indicator for the overall market but the lead can be long and variable. Nonetheless, there are chinks appearing in the bull’s armor.

Meanwhile, the heretofore gentle upward trend of interest rates has become somewhat more rigorous as yields rose across the maturity spectrum during the quarter with the key Treasury ten-year note yield rising more than twenty basis points. Although the current economic recovery was somewhat anemic prior to this year, the rate of corporate bond issuance has continued unabated. According to ICE Data Services, the total market value of outstanding corporate bonds has increased from just over $3 trillion in 2007 to just under $8 trillion today.

The Federal Reserve recently raised the federal funds rate to a range of 2%-2.25% and implied that additional increases lie ahead. Those additional increases will serve to raise debt service costs – a factor that will no doubt begin to weigh on economic growth at some point.

Speaking of the latter, second quarter real GDP registered a 4.2% annualized growth rate – the highest in many a moon as the virtuous cycle has kicked in with full force. With unemployment claims at historically low levels, jobs growth has been limited only by the scarcity of qualified job applicants. Even though wage gains remain relatively subdued, the jobs growth has translated into higher disposable incomes, higher discretionary spending, increased production, and, in turn, higher labor demand.

The PPI and CPI both remain slightly above the Fed’s 2% target level but overall inflationary pressures do not appear to be excessive. Energy prices have remained firm due to high demand resulting from global growth combined with OPEC’s supply constraints. Other commodity prices, however, have not exhibited oil’s strength. In fact, the Commodity Research Bureau’s Index actually fell 2.6% during the quarter. Commodity prices tend to lead the economy and other risk asset prices, about which we shall have more anon.

In the sporting news, the Cubs managed to blow a five-game lead in September to end the season in a deadlock with the Brewers for the top spot in the NL Central. After winning three divisional titles in as many years, this behavior is more like the hapless Cubbies of yore. After the historic collapse against the “Miracle Mets” in 1969, it was suggested that the team be moved to the Philippines and be renamed the “Manilla Folders.”

Dubbed the “metal with a PhD in economics”, copper has a long history as a leading indicator for global economic activity as well as other commodity prices. In fact, there is an old Wall Street adage, “Every bull market has a copper top.” Copper is widely used in a broad array of products and processes. Hence, rising copper prices are an indication of stronger economic activity while falling prices are an indication of economic weakness.

The chart below shows that copper began the year in a downtrend that extended into March before a rally began in the second quarter as the economy experienced the surge in GDP growth mentioned above. Despite a modest bounce of late, copper has been in a decline since mid-June even as the Dow and S&P were making new highs.

Although the price range of the chart is relatively narrow at only eighty cents, the decline since the end of last year is more than 15% and should, therefore, give us pause to consider if things have perhaps gotten overly exuberant in the financial markets. Standing alone, the copper price indicator is not sufficient to provoke undue concern. However, given the weakness evident in non-energy related commodity prices, the underperformance by the financial stocks, poor market breadth and extreme levels of investor optimism, it would be prudent to allow for at least a modest correction in one’s financial planning. Doctor’s orders.

Weaver C. Barksdale, CFA

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